Letters of Credit in International Trade: How They Work and Where They Go Wrong
Years ago, a large Spanish company came to us through its Spanish lawyer after completing a substantial international transaction. It had used a letter of credit to protect itself against nonpayment, but it had not been paid. Worse, the credit had been prepared with an error that left the company with far less protection than its executives believed they had. The letter of credit listed the wrong address for our client. That seemingly small mistake created a serious problem with the documents needed to obtain payment and gave the buyer an opportunity to resist paying. We eventually helped it get its money, but payment depended on the buyer choosing to do the right thing. That was precisely the risk the letter of credit was supposed to address.
I have spent much of my career handling international business transactions, and letters of credit still rank near the bottom of my list of favorite subjects. The idea is straightforward enough. A bank promises to pay when specified conditions are met, and the trouble lies in those conditions. A company can perform its contract, deliver exactly what its customer ordered, and still be unable to collect under its letter of credit. I do not like seeing companies commit to substantial international transactions on the assumption that having a bank involved means they no longer need to worry about getting paid.
What Is a Letter of Credit?
A letter of credit (LC or L/C), also called a documentary credit, is a bank's commitment to pay a specified beneficiary when that beneficiary presents documents that comply with the credit's terms. In a typical international sale, the buyer arranges for its bank to issue the credit in favor of the seller. The seller ships the goods and presents the required documents. If the presentation complies with the credit and the applicable rules, the issuing bank is obligated to honor its undertaking, subject to applicable law. For an exporter, the appeal is having a bank's payment undertaking rather than relying entirely on a foreign customer's willingness and ability to pay.
The most important thing to understand about letters of credit is that banks examine documents, not merchandise. A bank ordinarily does not determine whether the goods meet the buyer's specifications or whether the seller has fulfilled its contract. It determines whether the documents presented comply with the letter of credit. The same rule applies to importers, who can end up paying for defective merchandise because the seller's documents comply.
This principle is established in Articles 4 and 5 of the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits (UCP 600). These rules govern most international commercial documentary credits when expressly incorporated into the credit. They establish the independence of the bank's undertaking from the underlying sales contract and set out the standards for examining documents, honoring credits, and refusing payment. A buyer generally cannot instruct its bank to withhold payment on a complying presentation simply because it has changed its mind about the purchase. That independence is what gives the exporter protection, provided the credit has been properly structured and the required documents are in order.
How an International Letter of Credit Works
Suppose an American equipment manufacturer agrees to sell $400,000 worth of machinery to a new overseas customer. The American company does not want to manufacture and ship the equipment based solely on the buyer's promise to pay after delivery. The buyer, meanwhile, does not want to pay the entire purchase price before the equipment ships. The parties agree to use an irrevocable letter of credit payable at sight, and the transaction proceeds as follows:
- The parties agree on the payment terms. Their sales contract requires the buyer to obtain a letter of credit from a bank acceptable to the seller. The agreement identifies the required documents, payment amount, shipment deadlines, and other conditions.
- The buyer arranges for its bank to issue the credit. The issuing bank evaluates the buyer's credit arrangements and transmits the credit through established banking channels. An advising bank communicates the credit to the seller after checking its apparent authenticity.
- The seller reviews the actual credit. Before manufacturing or shipping, the seller confirms that the credit matches the agreement and that every documentary condition can be satisfied. If something is wrong, the parties arrange an amendment.
- The seller ships the equipment and presents the documents. The credit requires a commercial invoice, packing list, transport document, and a certificate from a particular independent inspection company. The seller must present these documents to the appropriate bank within the credit's deadlines.
- The bank examines the documents. Because this credit is payable at sight, payment becomes due upon a complying presentation and the required examination.
Now suppose the seller never arranges the inspection. The equipment is built correctly, ships on time, and reaches the buyer, but the certificate is missing, and the bank can refuse payment because the seller failed to present a required document. The seller must then obtain an acceptable amendment, seek a waiver of the discrepancy, or pursue payment under the underlying contract. An amendment requires the necessary parties' consent, and a waiver is not guaranteed. If neither resolves the problem, the seller may have to pursue payment under the sales contract, potentially through expensive international litigation.
The Types of Letters of Credit and When to Use Them
The type of letter of credit determines when you get paid, which bank owes you the money, and what you must do to collect it. I would want these questions settled before anyone agrees to the payment terms.
Irrevocable Letters of Credit
Under UCP 600, a documentary letter of credit is irrevocable even if it does not expressly say so. It generally cannot be amended or canceled without the agreement of the issuing bank, the beneficiary, and any confirming bank. This protects sellers against buyers changing the payment terms after the deal is made, but an irrevocable credit is not an unconditional one. The seller still has to present documents that comply with it.
Confirmed and Unconfirmed Letters of Credit
An unconfirmed letter of credit gives the exporter the issuing bank's payment undertaking. If that bank is financially sound and operates in a stable banking environment, this may provide adequate protection. A confirmed letter of credit adds a second bank's independent obligation to honor or negotiate a complying presentation. Suppose an American exporter selling to a buyer in a higher-risk market requires confirmation from an acceptable American or international bank. If the issuing bank fails to perform, the exporter has the confirming bank's separate undertaking, subject to the credit's terms and applicable law.
Confirmation costs money, and a bank is not required to provide it simply because the exporter requests it. I would rather see an exporter pay for confirmation on a substantial transaction than discover after shipment that the issuing bank's promise is difficult or impossible to enforce. Do not confuse an advising bank with a confirming bank, either. An advising bank checks the apparent authenticity of the credit and communicates it to the beneficiary. Advising a credit does not, by itself, make that bank responsible for payment.
Sight and Deferred-Payment Letters of Credit
Under a sight letter of credit, the responsible bank pays after a complying presentation and its examination of the documents, so payment is not necessarily immediate. A deferred-payment credit provides for payment at a later date, such as a specified number of days after shipment. This gives the buyer additional time to pay while providing the exporter with a bank undertaking to pay at maturity. The wait matters most to a seller that has already paid to manufacture and ship the goods. An exporter that needs cash sooner should ask its bank whether the deferred-payment undertaking can be financed or discounted, what that will cost, and whether the financing carries recourse against the exporter.
Standby Letters of Credit
A standby letter of credit generally serves as security against a party's failure to perform an obligation, rather than as the ordinary payment mechanism for each shipment. For example, a seller agrees to supply goods on 60-day payment terms, backed by a standby credit that permits a draw if the buyer fails to pay when due. Whether the standby actually protects the seller depends on its wording, including the required demand documents, drawing conditions, and expiration date. Standby letters of credit are frequently governed by the International Chamber of Commerce's International Standby Practices (ISP98), although UCP 600 or other applicable rules can also govern. The parties need to settle which instrument they want and which rules apply before agreeing on their payment terms.
Transferable and Back-to-Back Letters of Credit
These arrangements are particularly relevant to trading companies that buy goods from one company and resell them to another. Under Article 38 of UCP 600, a letter of credit must expressly state that it is transferable before it can be transferred to a second beneficiary, usually the underlying supplier. The transferring bank must also agree to make the transfer.
In a back-to-back arrangement, the intermediary uses the original credit as support for a separate credit issued in favor of its supplier. The two credits create separate banking obligations, so the documents and deadlines must work together, and the bank issuing the second credit has to be willing to take on the financing and associated risks. The ICC has a useful explanation of transferable and back-to-back letters of credit.
Why Letters of Credit Fail
Many letter of credit disputes begin long before the documents reach a bank. The people negotiating the sale agree on the commercial terms, but nobody makes certain that the banking requirements match what the seller can actually provide. The problem often comes to light after the goods have shipped, when the seller has considerably less bargaining power.
The Documents Contain Discrepancies
Documentary discrepancies are among the most common reasons banks refuse payment. A commercial invoice that conflicts with the credit, a shipment made after the latest permitted shipment date, an insurance certificate that falls short of the required coverage, or a certificate issued by the wrong organization when the credit specifies the issuer can each be enough to justify refusal. Banks sometimes reject documents for discrepancies that are not valid under UCP 600, however. Article 14 does not require the information in different documents to be identical. It requires that the information not conflict when read in context and according to international standard banking practice. Article 14(j) of UCP 600 now generally permits a beneficiary's address on a stipulated document to differ from the address in the credit, provided both are in the same country. There is an exception for certain applicant details on transport documents. UCP 500 did not contain this express provision, but even under those earlier rules, an address difference did not automatically justify refusing payment.
The ICC's International Standard Banking Practice (ISBP 821), published in 2023, provides detailed guidance on document examination, including how UCP 600 requirements apply to commercial invoices, shipping documents, insurance certificates, and other documents used in international transactions. Under ISBP 821, a typographical error that does not affect meaning does not make a document discrepant. A seller should understand these rules before preparing its documents, and a bank's refusal should be examined against them.
Payment Depends on a Document Controlled by the Buyer
Suppose the credit requires the buyer to issue a certificate confirming that the products are satisfactory. The seller ships the goods, but the buyer refuses to issue the certificate. Without it, the seller cannot make the required documentary presentation. The seller has effectively allowed the buyer to control whether it can obtain payment under the credit, which defeats much of the reason for using one.
Article 14(h) of UCP 600 generally requires banks to disregard a condition that does not specify a document demonstrating compliance. A credit that expressly requires a buyer-issued acceptance certificate is different because the certificate itself becomes part of the required documentary presentation. I would be extremely reluctant to let a client ship valuable merchandise under a credit that gives the buyer this much control over payment. If an inspection or acceptance step is necessary, base it on objective standards and documentation from a mutually acceptable independent inspection company. The underlying contract should address what happens if the goods fail inspection, what the seller must do to correct the problems, and how disagreements will be resolved.
The Seller Misses a Deadline
A letter of credit can contain a latest shipment date, a deadline for presenting documents, and an expiration date, and missing any of them can cost the seller payment under the credit. Under UCP 600, presentations involving specified original transport documents generally must be made within 21 calendar days after shipment, unless the credit provides otherwise, and always no later than the applicable expiration date. A credit can impose a shorter presentation period. The rules also contain provisions addressing certain bank closures and deadline extensions, but sellers should never plan around an assumed extension.
Waiting until after shipment to start thinking about the required documents is a mistake. The shipping schedule must allow enough time to obtain the paperwork, check it for discrepancies, make corrections, and present it. If the documents arrive late or contain errors that cannot be corrected before the deadline, the seller has created a payment problem that was entirely avoidable.
The Credit Is Fake, or the Bank Cannot Pay
Sometimes the letter of credit is not real. A dishonest buyer sends an impressive-looking document bearing the name and logo of a real bank that has issued no such credit. The exporter manufactures or ships the goods believing payment is secured and discovers the fraud only when it tries to collect. Have your bank authenticate the credit through established banking channels before relying on it. A document emailed by the buyer, however official it appears, is not sufficient. For other examples of forged trade documents and international payment fraud, see our guide to international business scams.
A genuine credit still leaves the question of whether the issuing bank can pay. Before relying on an unfamiliar bank, have your trade-finance bank evaluate its financial standing and the country risks affecting payment. The issuing bank has taken on a payment obligation, but that provides limited comfort if the bank is financially unsound or operates under restrictions that prevent it from performing.
Sanctions and Government Restrictions Prevent Payment
A properly prepared documentary presentation does not override mandatory law. Sanctions, foreign exchange controls, and other government restrictions can interfere with a bank's ability to pay or transfer funds. These risks deserve particular attention when a transaction involves a restricted country, a sanctioned party, or a sensitive product. The bank's location, payment currency, correspondent banking arrangements, and applicable sanctions regimes can all affect whether payment is permitted and the money can move. The ICC's guidance on sanctions clauses in trade finance instruments discusses how sanctions requirements and contractual clauses affect banks' obligations. For higher-risk transactions, investigate these issues before committing to manufacturing or shipment.
What Letters of Credit Do Not Protect Against
An importer wants to avoid paying for goods that never arrive or do not meet the agreed specifications, and a letter of credit protects against those risks only to the extent its payment conditions do. Suppose an importer purchases electronic components from an overseas supplier. The supplier ships the correct number of boxes and presents a complying commercial invoice, packing list, and bill of lading. The bank honors the credit. When the importer opens the boxes, it discovers that the components fail the agreed technical specifications. By then the bank has paid, and defective goods generally would not have relieved it of its obligation to honor a complying presentation anyway. The importer must look to its contract with the supplier and whatever remedies are available under the governing law. Serious fraud can create exceptions, but ordinary quality disputes do not automatically justify stopping payment.
The letter of credit needs to be coordinated with a sales or manufacturing agreement that covers product specifications, independent inspections, warranties, and remedies for defective merchandise. For companies buying products overseas, our article on international contract manufacturing and protecting your products and payments explains how these protections fit together.
When Is a Letter of Credit Worth the Cost?
Letters of credit are most useful when the amount at stake is substantial, the buyer is new or its finances are hard to verify, the buyer is in a country where collecting a debt is difficult, or the goods would be expensive to recover or resell if the buyer failed to pay. They can also make it possible for a seller to offer payment terms that would otherwise create unacceptable credit exposure.
Banks charge for issuance, advising, confirmation, amendments, document examination, and discrepancy handling, and those fees can be significant. Document preparation adds expense, especially when the shipment or required paperwork is complicated. For a relatively small transaction with an established trading partner, the additional expense may outweigh the benefit. I have no interest in recommending an expensive banking arrangement when a simpler payment structure provides adequate protection.
Before agreeing to the expense of a letter of credit, compare it with the other international payment arrangements available for the transaction. An advance deposit followed by a balance payment tied to shipment or inspection can work well in certain manufacturing transactions. A documentary collection allows banks to handle documents and collection instructions without providing the bank payment undertaking associated with a letter of credit. Export credit insurance can help protect qualifying foreign receivables against specified commercial and political risks. The U.S. International Trade Administration's Trade Finance Guide explains these payment methods and the circumstances in which businesses commonly use them. Our Payment Terms When Selling Overseas article gives examples of how companies have negotiated advance payments and used letters of credit to reduce their exposure. I would be far more inclined to recommend a letter of credit for customized equipment going to a buyer the exporter has never dealt with than for routine shipments to a customer with a long history of paying on time. Whether the credit needs confirmation is a separate question, determined principally by the issuing bank and the risks affecting its ability to pay.
Letters of Credit When Buying From or Selling to China
Our international lawyers regularly encounter payment disputes involving Chinese manufacturers and buyers. The concerns differ depending on which side of the transaction our client is on, and so do the payment arrangements we recommend.
Buying Products From China
Chinese manufacturers often want substantial payment before production or shipment, while their American and European buyers want to keep enough bargaining power to make sure the products meet the agreed specifications. On a large enough order, a letter of credit can be the compromise. The buyer can require specified shipping documents and an independent inspection certificate before the bank becomes obligated to honor a documentary presentation, but the buyer still needs a sound manufacturing agreement. A letter of credit does not establish product quality standards, determine ownership of tooling, or provide effective remedies when the supplier delivers defective products.
Letters of credit also come with costs and administrative requirements that make them unattractive for many smaller manufacturing orders. Some suppliers will not accept them, while others increase their prices to account for the additional work or banking expense. For many companies manufacturing in China, a negotiated deposit followed by a balance payment tied to a satisfactory pre-shipment inspection is simpler and more economical. Our article on China manufacturing payment terms explains how common deposit and balance arrangements affect a buyer's ability to deal with defective products and unreliable suppliers.
Selling Products to China
When you sell to a Chinese company, the danger is shipping the goods and never seeing the money. A letter of credit issued by a financially sound Chinese bank, confirmed by another bank if the transaction warrants it, can substantially reduce that risk. I would evaluate the specific Chinese bank rather than assume all Chinese banks present the same risks, and I would want to know exactly what documents the exporter must present to get paid. An excellent bank does you little good if the credit's conditions cannot be satisfied.
The exporter should find out whether the Chinese buyer can lawfully import and pay for the goods. A bank undertaking cannot cure a transaction that violates applicable restrictions or depends on approvals the buyer cannot obtain. Our article on how to ensure you get paid when doing business with Chinese companies addresses additional contract and payment protections.
How to Structure a Letter of Credit Before You Ship
The time to work out the letter of credit terms is before the parties sign the underlying sales contract. I would want the seller's trade-finance banker involved at that stage, especially on a large transaction. Once the seller has committed to manufacturing or shipped the merchandise, fixing a problem with the credit often requires the buyer's cooperation, and by then the buyer's interests no longer line up with the seller's.
The sales contract should specify the type of credit required, the amount and currency, the issuing bank's acceptable qualifications, whether confirmation is necessary, and which party pays the banking charges. It should establish when the credit must be issued and what happens if the buyer fails to provide an acceptable credit on time. Give the seller the contractual right to suspend production or shipment without liability for the resulting delay if the buyer fails to provide the agreed payment security by the required date.
Go through every required document and ask whether the seller can actually obtain it, who must issue it, and whether its contents can be made consistent with the underlying contract. Pay particular attention to inspection certificates, shipping documents, insurance requirements, and any conditions dependent on the buyer's approval. I would question any certificate or special condition that serves no real commercial purpose. Every additional requirement creates another opportunity for a discrepancy. If the credit will involve electronic records, the ICC's eUCP Version 2.1 provides a framework, but the credit must expressly incorporate those rules and properly address electronic presentation. Sending a scanned document by email does not automatically satisfy a credit requiring a paper original.
The credit must also work with the transaction's shipping arrangements. The agreed Incoterms determine important delivery responsibilities, costs, and risks, and the documents required by the credit should correspond with those arrangements. Suppose the sales contract calls for FOB delivery, but the letter of credit requires the seller to provide a cargo insurance certificate. Under the ordinary FOB allocation of responsibilities, the seller is not required to arrange that insurance. If the seller has not purchased the required coverage, it cannot produce the certificate the bank requires for payment. That is the sort of problem I would expect someone reviewing the transaction to catch before the goods are shipped.
The latest shipment date, presentation period, expiration date, and place of presentation should leave enough time for the seller to complete the transaction and correct foreseeable documentary problems. An exporter should not accept a credit that becomes practically impossible to use because of unrealistic deadlines. Once the credit has been issued, review its actual terms against the contract rather than assuming the bank issued exactly what the parties requested. The people responsible for shipping and preparing documents need to understand the credit before the merchandise leaves the factory. A freight forwarder can be excellent at moving cargo and still not know how to prepare a complying documentary presentation. The seller should identify who is responsible for each required document and have the presentation reviewed before it reaches the bank.
What Happens If the Bank Refuses Payment?
If a bank refuses payment because of documentary discrepancies, do not assume it has applied the rules correctly. Get its written refusal notice and have someone who understands UCP 600 and ISBP 821 review it. I would not accept a refusal involving a substantial amount of money without first determining whether the bank has a legitimate basis for withholding payment.
Under Article 14 of UCP 600, the issuing bank, confirming bank, and a nominated bank acting on its nomination each generally have a maximum of five banking days following the day of presentation to determine whether the documents comply. Article 16 governs notices of refusal. A bank refusing to honor or negotiate must give a timely notice identifying the discrepancies and explaining how it is handling the documents. Under Article 16(f), an issuing or confirming bank that fails to comply with Article 16's requirements is precluded from claiming that the documents did not constitute a complying presentation. This matters when a bank attempts to justify nonpayment with late, incomplete, or shifting explanations.
Some objections in a refusal notice are valid and can be corrected if sufficient time remains. Others reflect an incorrect application of UCP 600 or international standard banking practice. The issuing bank may seek the buyer's waiver of discrepancies, but the buyer is not obligated to provide one, and requesting a waiver does not extend the bank's examination period. Expiration does not eliminate the bank's obligation to examine a timely presentation, but it can prevent a seller from correcting defects through a new presentation.
Fraud and forgery raise separate issues, which Uniform Commercial Code Section 5-109 addresses in the United States, including the limited circumstances in which a court can enjoin payment. The precise standard and available relief depend on the governing law and the circumstances. A dispute against the issuing or confirming bank is legally distinct from a claim against the buyer under the sales contract. Once a substantial credit has been dishonored, evaluate these claims quickly, before documentary deadlines or other practical problems eliminate your options.
Have Someone Who Knows Letters of Credit Review Yours
Our law firm handles a tremendous amount of international business work, but I have never believed that every international lawyer is qualified to review a complicated letter of credit. Our international manufacturing lawyers help companies structure the underlying contracts and payment arrangements. If your company is planning a substantial international transaction involving a letter of credit, I would want someone who regularly works with these instruments, along with an experienced trade-finance banker, to review the banking documents before you commit to production or shipment.
